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Wednesday, June 27, 2012

Srikanth owns stocks of ABC Ltd. After he learnt about the concept of futures and hedging from professor Nicky, he used the futures contracts on ABC Ltd. to hedge the risk of a downward slide in the share prices. Unfortunately for him, just a few days after he entered the contract, the company announced its quarterly earnings and the stock prices have gone up steadily ever since.

The value of his stocks are now higher. That’s good news. But he does not intend to sell the stock. On the other hand, his losses are very real! He started getting margin calls from his broker. So he closed out his position in the futures market, before his losses become larger.
However, this led him to think of how it would be great if he could have the good part of futures without the obligation to honor the contract!

“Naah…I guess that would be too good to be true…”, thought Srikanth. Nevertheless, he walked into prof. Nicky’s room to share his experience with futures with the professor.

Prof Nicky: Well, as a matter of fact, such instruments do exist. They are called Options. By buying an option, you can lock in a price but can choose not to exercise your option if the market offers a more advantageous price.

Srikanth: Buying an option?

Prof. Nicky: Perceptive as always Srikanth. Yes, you buy an option. Since you have a right but no obligation to trade your stock at a pre-determined price, you pay a premium. Else it would be like being able to have your cake and eat it too!

Srikanth: Hmmm… though that would be great, I suppose no one would sell options for free, so this situation seems fair enough. So how about if I want to be able to sell a stock? Can I buy an option to sell a stock?

Prof. Nicky: Yes Srikanth, weirdly as it sounds, you can buy an option to sell a stock… It’s pretty interesting actually, there are fundamentally two types of options, a call option which allows you to buy stock and a put option that allows you to sell stocks. Buying an option allows you to, at a cost, transfer risk to the seller of the option. A simple call or a simple put option are also referred to as plain vanilla options.

Srikanth: Professor, in the futures market, we can buy and sell our contracts any time. Can we do the same in the Options market?

Prof. Nicky: Indeed you can buy and sell them anytime at the price (premium) in the market. However, you can exercise your options anytime only if they are American in nature. Now… before you ask… no you don’t need to be in America to be able to trade in American style Options. It’s just nomenclature.

Options which can be exercised anytime up to expiration are called American Options, where as those which can be exercised only on the day of expiration are known as European style options. Both kinds of options are traded all over the world. In India, the index options are European in nature, while the stock options are American!

Srikanth: They don’t seem too plain to me… But why would anyone sell options? The seller seems to take on a lot of risk!

Prof Nicky: Great question! Simple answer — for the premium. The person writing the option believes that the probability of the option being exercised is very low. So he gets to collect and keep the premium.

Srikanth: Wow!… this is information overload for now..but how about we continue this discussion next week and you tell me how someone like me can use options?

I had a strange dream last night. I saw a young lad sitting in front of a computer and it’s raining thousand rupee notes. He is soaked in those notes, enjoying every bit of it. I look closer to see what is on the computer screen. I wake up with a start as soon as I realised that the screen was nothing but a derivatives trading platform and the young lad was Srikanth.

I had explained futures to him a few days back. What has been bothering me is that I did not explain the downside risks of investing in futures as profoundly as I should have. Futures are extremely leveraged contracts. And if not used wisely, they can wipe out fortunes. Often people mistake them as magic wands due to this very property of leverage. Let me explain.

Leverage in finance is very much like the leverage we learn about in physics. It amplifies effort, or in this case, the impact of our investment. When one buys a futures contract, she does not need to pay the full amount. For example, if you were to buy 100 shares of Reliance Industries Limited (RIL), you would need to pay a total of Rs72,700 (Rs727 per share times 100).

On the other hand, in the case of Reliance Futures, one contract of 100 shares costs only a small percentage. This amount is known as the initial margin and is calculated based on a system known as Standard Portf¬olio Analysis of Risk (SPAN).This system takes into account the volatility of the underlying stock.

Let us say that according to SPAN, the initial margin should be 10% of the contract value (Rs72,700). This would mean that you end up paying only Rs7,270 to control 100 shares of RIL. That means you are highly leveraged. Now if the stock price goes up, you gain as the price of RIL futures also go up and you can sell them at a profit.

Let’s say you sell them at Rs750 — your profit will be a total of Rs2,300 (750-727 times 100 shares). Hence your profit in percentage is 2,300/7,270 times 100, that is 31% on an investment of Rs7,270 Here is where we need to remember that leverage doesn’t always mean more profits, it merely amplifies things, so in case of a loss, the amount lost is also multiplied by the same factor.

Let’s assume that the stock price goes down by the same Rs23. That is you sell RIL futures at a loss. Once again, your losses are much higher than they would be if you had invested in the stock instead of the futures.

Unfortunately, people forget that the prices can go down. They feel that they can make huge profits with little investment in the case of futures. And I must explain this to Srikanth before he starts dr-eaming of big money and invests recklessly in the futures market. The exchanges do take measures to ensure that the risks are taken care of by adjusting the initial margin on a daily basis.

The investors get margin calls to top up their initial margin accounts in the case of a falling market. This keeps the investors informed of how much they are losing or gaining on a daily basis. The investors can close their positions or take offsetting positions before they end up losing a lot.

But this system of marking to market everyday also means that in addition to profit or loss at the end of your contract, you have to keep track of cash flows needed to stay invested. Otherwise, a sharp move can cause your position to be closed out prematurely when the contract would have been profitable at expiration.

Monday, June 11, 2012

Srikanth: Hi professor, sorry I had to leave in the middle of our conversation on futures last week. You told me that futures are contracts that help people hedge their portfolios. Please do tell me how people like me can use futures as a part of our investment portfolio.

Prof. Nikki: Futures are very powerful instruments for an investor to manage his risk. But the importance of learning about them before trading in them cannot be overstated because they can also be pretty complex. And even after reading about them, it is best to start small.

Srikanth: How would you suggest we start using futures?

Prof Nikki: I think the best way would be to start with simple contracts to hedge your position on some stock that is experiencing some volatility.

Srikanth: Whoa… That’s a lot of jargon in one sentence… Hedging? And how would you define volatility?

Prof Nikki: Ah! Once a student, always a student. I did explain hedging to you last week. As usual, you did not pay attention! Let me explain again.

Hedging refers to taking a position (or trade) to offset your initial position. Let me try and make it clearer, if you own a stock (you are long stock) , you stand to gain if the stock price goes up, therefore, by entering a trade where you stand to gain when the stock price goes down, you will offset the initial position. You can do this by entering a futures contract to sell (short position) the stock at a certain time and price in future.

Volatility is a measure of variation of prices. A more volatile instrument is one which has more drastic price movements.

Srikanth: So then we would profit both ways? And what if I do not want to sell my stock?

Prof Nikki: Don’t you wish! Unfortunately no, because which¬ever way the stock moves, the gains from one position would be offset by losses from the other.

And you don’t really have to sell your stock if you don’t want to, you can either close out your po¬sition by entering a contract to buy stock (long position) or if the contract allows it, you can settle by paying the equivalent cash value.

Srikanth: Hmmm… So if the losses and gains keep cancelling and doesn’t give me additional gains, why should I go through the effort of entering into a futures contract?

Prof Nikki: One reason could be that you really like a stock that you own, something that has been a good solid company, pays good dividends etc, but is presently experiencing some trouble. In this case, you do not want to sell yet, but want to protect yourself from a very sharp decline in price…so you lock in a price and wait.

Srikanth: That makes sense, I do have a few stocks like that. With the economy in doldrums, the stocks are indeed showing signs of what you call ‘volatility’.

Prof Nikki: Yes. But do remember that futures are financial instruments and not magic wands that eliminate risk. Be sure to read up on them in detail, especially about margins before you put your money in them.

Monday, June 4, 2012

Price manipulation and role of unscrupulous brokers in capital markets has historically been a subject of great concern to market participants and Governments since it has an important impact on market efficiency. Price manipulation can occur in many ways, from false information to accounting and earnings alteration to stock price manipulation or what Allen and Gale term “Trade-based manipulation.”

Allen and Gale (1992) confirmed that it is possible for an uninformed speculator to make profits from ‘trade-based manipulation' with large traders frequently buying and then selling substantial blocks of stock.

Evidence

Anecdotal evidence from the Indian capital markets suggest that many such price manipulation strategies exist reducing the market efficiency, and also indicate the existence of front-running by traders primarily before large trades. The fact that SEBI has sent more than 500 show-cause notices in the past four years to various brokers, financial institutions and traders regarding these prohibitive activities support the point furthermore.

Harris (1997) points out that, front- runners are on the lookout for “large traders” who strongly want to complete a trade. Then they make short-term trading profits by front-running these large traders. SEBI defines a “bulk” deal as “all transactions in a scrip (on an exchange) where total quantity of shares bought/sold is more than 0.5 per cent of the number of equity shares of the company listed on the exchange.”
The quantitative limit of 0.5 per cent could be reached through one or more transactions executed during the day in the normal market segment. In an effort to improve transparency in the Indian capital markets, SEBI mandated the disclosure of bulk deals in the year 2004.
An analysis of 80,704 trades over the past six years to see if there is any evidence of “trade-based manipulation” in the context of bulk trades on NSE and BSE, for all NSE listed stocks, by Ms Nupur Pavan Bang (ISB, Hyderabad), Mr Chakrapani Chaturvedula (IMT, Hyderabad), and Mr Nikhil Rastogi (IMT, Hyderabad), shows that there is ample evidence of front running, with significant impact of bulk trades on the share prices.

A person investing in a small-cap stock, ten days before the bulk deal and off loading it the day after the bulk deal can make 9.58 per cent in this 12-day period . Similarly, he can make 4.79 per cent in the case of large-cap stocks in 11 days . Practical Difficulties

The results are obvious as the finding liquidity for bulk deals in small-cap stocks is more difficult and may signal the presence of more information in the trade. Also, because of liquidity issues, the broker might need more time, and may contact more people to find buyers/ sellers for the small-cap stocks. This results in more information leakage and front running.

Front-running facilitated by information leakage distorts the market integrity and can create adverse selection problems that limit market participation and inhibit efficient capital allocation. Therefore, a much stronger role for Government regulation is required to discourage manipulation in emerging markets. Behavioural pattern

They also find that while the buyer-initiated trades result in a cumulative return of approximately 4.2 per cent over a 21-day period, but the seller-initiated trades do not see an expected dip in price over the same period.

This is in tune with the proven investor behavior of reacting swiftly to good news (bulk buying indicate good news) and being reluctant to react to bad news (bulk selling indicates bad news).

While there is need for stringent norms to regulate the bulk trades, the regulator must pay special attention to bringing more transparency and liquidity in the small-cap stocks. Due to the illiquidity in the small-cap segment, the intermediaries are able to front run the bulk orders of their customers more easily.
The surveillance activities taken up by SEBI, followed by investigative actions, need to be spruced up.

In a research carried out by Allen and others, published in the year 2007, they find that the ratio between the number of investigative actions taken up by to the number of companies under its jurisdiction was 0.09 for SEBI which is dismal when compared to SEC's (Securities Exchange Commission) 0.52. Things do not seem to have improved in the recent years.

This article was originally published in Postnoon on June 1st, 2012 (Co-Authored with Amulya Chirala)

http://postnoon.com/2012/06/01/what-futures-mean-for-us/51486

Prof. Nicky: Srikant, think of a bread factory. They bake hundreds of kilograms of bread every day. This means that they use hundreds of kilograms of wheat every day. The price of wheat fluctuates frequently but the company cannot really change the price of a loaf of bread every time the price of wheat moves up or down. While wheat becoming less expensive may not worry the owner of the factory much, he would constantly worry about rising price of wheat.

Now think of a wheat farmer. He lives in fear of wheat prices dropping when it is finally time to harvest the crop. If they had a mechanism to fix the price of wheat at a certain mutually agreeable price, both of them would be happier people because of the elimination of uncertainty. Sure, the farmer is sacrificing the potential very high profits if the price of wheat were to sky-rocket! Similarly, the bread manufacturer is sacrificing the higher profits he might make if the wheat prices were to nosedive. But they are assured of being in business.

Srikant: Interesting thought. Prof. Nicky, it would indeed be very useful for both of them to enter into such an agreement.

Prof. Nicky: Yes. The elimination of price risk is known as hedging. And it can be done through financial instruments known as ‘Forwards’. Forwards enable the two parties to fix the price, quantity and quality of wheat that will be traded at some point of time in the future. Forwards are highly customisable agreements between two parties, usually via a broker. Since there is not much regulation governing the forwards, there exists a risk of counterparty defaulting on the contract when market prices are more favourable to them.

To eliminate the risk of default, there is a similar class of instruments traded on exchanges. They are known as ‘futures’. The primary difference between futures and forwards is that there is a “margin” or a safety deposit collected by the broker (or clearing house) from the trader which is adjusted daily to reflect the changes in the prices of the asset on which the contract is written (underlying). This process of adjusting the margin is called ‘marking to market’. It is the equivalent of rewriting a forward contract daily.

Srikant: Hold on Professor. Why are you telling me all this? I am neither a farmer, nor a baker.

Prof. Nicky: True. But you are an investor. You recently invested some money in the stock market.

Srikant: Yes. But I am still not able to see the connection between my equity investments and these futures contracts.

Prof. Nicky: You know how volatile the markets are now a days. With the rupee falling, the fiscal deficit increasing, Euro crisis and so on. Wouldn’t it be nice if you could hedge your risk in the stock markets too?

Srikant: Ah! Now I know where you are going!

Prof. Nicky: Just like a farmer and a baker can hedge the price risks involved in their business, an investor too can hedge the risk of her portfolio of stocks being subjected to undue price movements due to external factors. Exchanges like NSE and BSE offer futures contracts on stocks and even the index.

Also, Srikanth, your father owns a jewellery business. You can tell him about futures contracts which can help him hedge the price of Gold. Futures contracts on commodities are traded on exchanges like MCX and NCDEX.

Srikanth: Prof. that reminds me, I’ve got to rush home. Got to take dad for a doctor’s appointment. But this is all very interesting and we’ll continue from where we are leaving, the next week…